Overview
I will start the analysis with DuPont's decomposition of Return on Equity (ROE) for the past four years and then calculate liquidity and leverage ratios. Thirdly, I will compare Deere's Return on Invested Capital (ROIC) with its Weighted Average Cost of Capital (WACC) and compare those figures with its US competitor, Caterpillar CAT. Then, to assess the quality of earnings, I will compare Deere's Cash Flow from Operations (CFO) with its Operating Profit (EBIT) for the last five years. Next, to delve deeper into its cash flow situation, I will analyze cash return on assets, liquidity, funding, and leverage capacity relative to its cash flow and compare them with Caterpillar's numbers. Finally, I will value John Deere as of 2023 using the Free Cashflow to Equity method.
DuPont Decomposition of ROE
I have excluded the effects of unusual charges and unconsolidated affiliates to better understand its recurring operations, just in case. Overall, there appears to be an increasing trend in ROE, which is a good sign. Net Profit margin, Return on Assets (ROA), and financial leverage are healthy and improving, indicating improving profitability at Deere.
Liquidity Ratios
There is a decreasing trend in current and quick ratios, meaning DE may not generate enough cash from working capital accounts. DE is experiencing a decreasing trend in Days Sales Outstanding (DSO) and inventory on hand. However, the cash conversion cycle of Caterpillar appears better than that of John Deere. So, DE needs to work on improving the collection period. As seen from the above liquidity ratios, DE pays cash on average 194.64 days before generating money from collections and inventory turnover. At the same time, Caterpillar ends up spending cash on an average of 167.66 days (26.98 days less than DE) before generating money from collections and inventory turnover. Being Dissatisfied with liquidity ratios, especially with collection ratio, let us analyze Days Sales Outstanding deeper.
Common size balance sheet analysis shows that Finance Receivables represent 40% of total assets for DE compared to 26% of total assets for CAT. Analyzing the DSO of DE compared to CAT for Finance Receivables shows that in 2022, DE had a DSO of 111.9 days, whereas CAT had a DSO of 55 days. So, DE is facing issues in the collection period comparatively. Moreover, taken from both the companies’ 2022 10 K annual reports, aging analysis shows that, on average, past due balances at DE increased slightly more than that of CAT despite the similar revenue growth. Similarly, an increase in DSO in Trade Receivables in 2022 at DE compared to 2021 could indicate earnings quality issues that could be related to its revenue recognition policy of sales incentive accrual, whereby DE deducts an estimate of future sales incentive costs from the sales price and total sales accrual is recorded in Trade and notes Receivables and accounts payables on the balance sheet. Even if the company increased the estimated sales incentive costs in 2022, that should not lead to a corresponding disproportionate increase in receivables.
DE Leverage Ratios
Even though DE is highly levered with Long Term Debt to Equity and Total Debt to Capital ratios higher than the industry average, as seen in Figure 1, its capital mix is improving because, as seen in Figure 2, the trend shows increasing equity at 23% and decreasing long term borrowings at 77% in 2022 from 2019. High borrowings could be because of high Capex or high investments. Hence, let’s compare the Return on Invested Capital (ROIC) with the Weighted Average Cost of Capital (WACC) to gauge the company’s success in creating value for its shareholders by efficiently allocating capital to profitable investments.
Return On Invested Capital Analysis
Since DE's ROIC is higher than its WACC, as seen in Table 1 above, we can conclude that it allocates its capital efficiently to profitable investments. The difference is even higher than that of Caterpillar. However, one should note this metric has its limitations. Concerned with its liquidity ratios and receivables analysis, I would like to analyze DE's quality of earnings by comparing its cash flow from Operations (CFO) with its Operating profit (EBIT) for past years.
Quality of Earnings Analysis CFO vs EBIT
Deere’s CFO has been persistently lower than its operating profit, as seen in Figure 3, indicating the low quality of earnings or earnings manipulation. Moreover, compared to Caterpillar’s (CAT) CFO/EBIT ratio, as seen in Figure 4, DE seems to have lower-quality earnings, which means that EBIT is biased and may not be a reliable metric in the previous calculations. Concerned with low-quality earnings, inferior liquidity, and high leverage, I would like to analyze DE’s funding and liquidity ability relative to its cash flows.
Cashflow Ratios
DE’s negative trend, low cash return on assets, and low cash flow ratios suggest inferior liquidity and funding ability relative to cashflows, particularly in 2022. At the same time, Caterpillar has maintained healthy cash flow ratios. These results should portray a cause of concern for an analyst considering John Deere.
FCFE Valuation of John Deere
Deere has four main segments 1) Production Precision & Agriculture Equipment segment 2) Small Turf & Equipment segment 3) Construction & Forestry segment 4) Financial Services segment. Based on historical analysis and reports from Bloomberg, Agriculture Equipment, Construction Equipment, and Forestry Industries are expected to grow between 4-5%. As per historical trend analysis, the company’s sales growth has been more than twice that of industry sales growth. So, it is safe to assume annual average sales growth of around 11%-13% from 2024 onwards. Since the first quarter results reported an increase of 5% YOY in sales, the company can be expected to make more than 15% annual sales growth in 2023, considering that management mentioned that order books are full through 2023, the demand environment across the segments look healthy, management expects a decrease in supply chain backlogs, and forecasts increase in construction equipment due to infrastructure spending.
I have decided to value John Deere using the FCFE method for different values of growth rates and cost of equity. In scenario analysis for different values of growth and cost of equity, I have calculated different prices per share of John Deere. Based on those prices, I have estimated a target range of prices for John Deere with low and high estimates.
The following assumptions are made:
1) I have excluded one-time gains, losses, and expenses from Net income, such as gains on the discontinued joint venture with Hitachi, Russian impairment losses, and bonus payment as part of the Labor union contract expensed in 2022.
2) Depreciation & Amortization expenses are calculated as the average % of respective assets base for the past five years after considering forward-looking estimates.
3) Incremental working capital is calculated as 42% of the change in sales.
4) Capex is taken at a median of the last five years at 7% of net sales.
5) Principal and interest payments are based on the company's expected and estimated payment schedules from its annual 10 K report and historical averages.
6) Borrowings are estimated using the average company's borrowings in the past five years.
7) In this scenario, the Cost of equity of 9.24% is calculated using an estimated risk premium of 4.45% that is based on the geometric mean of S&P 500 past market performance above the 5-year yield on Treasury bonds, the 5-year monthly historical beta of John Deere of 1.10 and the current yield on 5-year Treasury bonds of 4.26% as of March 2023 at the time of analysis.
8) In this scenario, net sales growth is assumed to be an average of 11% per annum.
9) In this scenario, Cashflows are discounted at the Cost of equity of 9.24%.
10) A Consensus Forward P/E estimate of 13.9 is taken from Nasdaq's analysis https://www.nasdaq.com/market-activity/stocks/de/price-earnings-peg-ratios
11) Since we have estimated earnings in 2027, we can find the terminal stock price in 2027 from the consensus forward P/E estimate.
Scenario Analysis
John Deere is undervalued at $400.79 as of Thursday, March 30, 2023. FCFE valuation shows John Deere to be fairly valued at a median price of $429 per share, with a low estimate of $405 and a high estimate of $455.
Conclusion
Given DE’s low liquidity, high leverage, low CF ratios, and the possibility of earnings manipulation to a certain extent, I would recommend a Hold position on John Deere even if the fundamental analysis shows the market undervalues it. I would advise investors to wait and see whether DE’s conditions improve concerning the above ratios.